-by Kanika Jain & Ashwini Nag
The world was left in awe after an army of retail investors set their minds upon sending a message to what they perceived as deep-pocketed investment giants indulging in borderline unethical practices like short selling, by causing a steep and highly unanticipated increase in the price of shares of GameStop Corporation, which was followed by a rise in the stocks of Blackberry, AMC Entertainment Holdings Inc. and American Airlines. In this article, the authors provide a brief introduction to the concept and legality of short selling, examine the circumstances surrounding the GameStop stock and discuss the regulatory framework in India that inherently disallows such a situation from ever arising.
What is short selling?
Short selling is essentially a position where an investor borrows some shares of a stock or other asset which he believes will decrease in value in the near future, at a borrowing fee. He then sells these borrowed shares to other investors who are inclined to pay the market price for the same. Since the shares are borrowed only for a limited period, the investor bets that the price of these shares will fall. Before the expiry of the borrowing period, the investor buys back these shares from the market at a lower price compared to what he sold at. He then returns the borrowed shares, after retaining the profit he earned from this speculation.
For example, let’s consider the following series of events:
- A borrows 100 shares of company X, at the rate of Rs.100 each, on 1.1.2020. The expiry date before which these shares must be returned is 1.6.2020.
- A then sells these shares at the market price, i.e., for Rs. 10,000.
- During this period, the price of that stock reduces and comes down to Rs. 50 per share.
- A then purchases 100 shares of that stock at market price Rs. 50, i.e., a total sum of Rs. 5,000, and returns these shares.
- Ergo, the amount earned by A can be calculated as: Rs. 10,000 – Rs. 5,000 = Rs. 5,000 (excluding the borrowing fee and interests, if any).
While investors who indulge in short selling practices undertake a thorough risk and return study, it is imperative to note that the risk of loss in short selling is supposedly unlimited. This is mostly due to factors like prices of asset which may even climb to infinity.
Short selling may be termed as a major exception to most principles of the market. This is because- conventionally, when an investor buys certain shares of a stock, he expects the price to rise up, hoping to sell the shares at a profit in the future. On the other hand, short investors bet on, and profit from a fall in security’s price. There is a much higher risk to reward ratio in this case; at the same time, losses can mount quickly and infinitely as well.
The Short Squeeze Threat
To understand the GameStop case, it is pertinent to explain one of the several risks involved with short selling, which is short squeeze. It is a situation where a stock is vigorously shorted with a soaring short float and days to cover ratio. This ratio essentially measures the expected number of days the investor has to close out a company’s shares that have been shorted by it.
A short squeeze happens when the price of the stock rises, and the short sellers have to cover their trades by buying back their short positions. Consequentially, this buying may turn into a feedback loop which further increases the value of that stock. Subsequently, this demand for shares will attract more buyers which will push the stock even higher. As a result of this loop, the short sellers suffer huge losses by buying back the shares at such a steep price to square off the sale.
The GameStop Phenomenon & Legality in the USA
A clear example of the risks involved with short selling, albeit unconventional, was what the Reddit group, WallStreetBets was able to pull off in the last week of January 2021. The stock of GameStop was consistently decreasing and hit a low of $2.57 in 2020 which rose to $18.84 on 31 December, 2020 after several institutional investors, including a $13 billion hedge fund, Melvin Capital, decided to short this stock. Even though the value of stock increased steadily, other investors bet against GameStop by resorting to short selling a huge number of shares.
At this point, the army of retail investors on WallStreetBets took the matter into their hands and decided to purchase GameStop shares to push the price up and put pressure on these short sellers, aiming to create a position of short squeeze. As eccentric as it sounds, it soon gained popularity on social media, especially after Elon Musk, CEO of Tesla Inc. shared a link to the group on his Twitter account, with the caption ‘#Gamestonks’.
The effect of this campaign was that any short seller who had borrowed GameStop earlier and sold them for $18.84 per share, had to pay $301.16 per share to buy them back and return to their owner. Since the price was increasing, the hedge funds were forced to buy back these shares before their value increased further. As discussed above, this created a loop where the value of stock increased further, causing more and more loss to the hedge funds. Hence, the short squeeze as envisioned by the Reddit users, or even better, had taken place, inviting criticism from these deep pocketed hedge funds who claimed to be in favour of upholding market ethics and non-manipulation.
A question that has come across almost every person’s mind is whether this speculation was legally permissible in the United States. The answer is yes. Short selling as a practice is quite prevalent in the market and has been for a long time. The Securities and Exchange Commission (SEC) adopted Rule 10a-1 in 1937, which is also known as the uptick rule. It provides that market participants can legitimately sell short shares of stock but only if this occurs on a price uptick from the preceding sale.
However, short sales on downticks, with some exceptions, were forbidden. The object of this rule was to prevent short selling at lower prices, which is a strategy aimed at artificially driving the stock price down. The uptick rule allows unrestricted short selling where the market is moving up, thereby increasing liquidity and maintaining a check on the upside price swings.
It is pertinent to note that this uptick rule had been eliminated in the year 2007, after a study that concluded that it was not effective to curb abusive behaviour. Instead, the rule carried the potential to limit the market liquidity. Therefore, naked short selling was prohibited in 2007, while normal short selling continues to be legally backed.
It is pertinent to note that the USA has the most liberal laws in the short selling paradigm compared to other countries across the world. Short selling in financial stocks was completely prohibited by several countries including Australia, Canada and most European countries after the global financial crisis in 2007- 2008.
Short selling under the Indian mechanism
With the modern mode of demat trading being introduced in India in the mid-90s, short selling was suspended from 2001 until 2008 as a result of the controversial market crash and immense scrutiny on the Bombay Stock Exchange’s president in light of allegations of insider trading. The Securities & Exchange Board of India (SEBI) re-permitted it in 2008 through the Securities Lending & Borrowing (SLB) mode without any restriction on the nature of investors, but with several guidelines in place for institutions and specifically, for the derivatives market. Significantly and in an opposing stance to the USA, naked short selling is prohibited in India; hence, sellers do not have the liberty to buyback the security at any time they desire and must mandatorily deliver it back to the lender at the time of settlement. In association with the regulatory approach, institutional investors are forbidden from day trading and attempting to short sell in an intra-day period. This means that hedge funds like the American companies currently suffering loss would not be allowed to short stocks on a day-by-day basis in the first place in an Indian scenario.
SEBI: The common investor’s guardian
The contemporary Indian stock markets do not witness much short selling in the equity segment and much of this can be attributed to the SEBI’s willingness to approach it openly only in the futures and options market. Before stocks can be shorted, they must be deemed eligible post timely monitoring. The Indian regulatory framework views the investor as an entity to be protected and consequently, the maximum amount that can be shorted is merely 20% of the stock’s market capitalization (termed the market-wide position limit). This saves amateur retail investors the woe of enormous capital loss upon the stock price declining; the rather contradictory legal position in the USA can perhaps be paraded as the cause of the ‘anti-establishment’ sentiment in favour of the latest GameStop short squeeze. Considering the reluctance of SEBI to grant further liberties to investors, it is highly unlikely that a squeeze of such a large capacity would occur in India.
SEBI’s role in banning circumstances that would lead to massive stock volatility and speculation goes beyond designating the futures and options funds that can be shorted; penalties imposed range from 0.5% of the amount to 1%, depending upon the value defaulted on by squaring the stock after the prescribed settlement time period. Another instance of the investor-preservation assessment can be observed through the SEBI press release in March, 2020 curbing the possibility of a crash due to increased pessimism-derived liquidity on the eve of the worldwide Covid-19 economic crisis by imposing restrictions on short selling in the Indian stock exchanges. The measures, akin to those undertaken by several European markets (but not the American ones) included a mammoth rise in penalties and a rule laying down that the short positions in the derivatives market must be less than the value of the security’s underlying stock or asset. The justification provided examined the ‘robustness of the risk management framework’ in the non-disruptive functioning of Indian settlement cycles. Certainly, such a regulatory charter can be lauded when placed in the context of the American situation encouraging a free-for-all attitude, veiled behind the million-dollar capital losses suffered by individual investors and companies with in-decline stocks.
Suffice to say, short selling’s growing unpopularity has worried Wall Street, with complaints and petitions being filed with the SEC to limit the massive number of buys undertaken by retail investors to manoeuvre a short squeeze. Social media on the other hand, has rejoiced at the humiliating loss of more than 50% suffered by Melvin Capital and other hedge funds in January itself. Whether the American markets will witness the birth of new regulations remains to be seen- the SEC will have to pick a side between either nursing the wounds of disgruntled investment giants contributing millions to the economy or putting on its colours of populist agenda. Perhaps a glimpse at the SEBI’s overview on short selling might re-assure investors that risk and return can be synced even without the sell-first, buy-later policy.
Views are personal.
Image credits: Amnesty International
ABOUT THE AUTHOR
Authors are III Year, BBA LLB (Hons.), Symbiosis Law School, Pune